SINGAPORE INSTITUTE OF TECHNOLOGY

BACHELOR OF ACCOUNTANCY WITH HONOURS PROGRAMME

ACC2007 COMPANY ACCOUNTING

TUTORIAL 4 – ACCOUNTING FOR LEASES

Question 1

For each of the scenarios below, assess whether a contract is a lease from the viewpoint
of the customer:

Case A
Co. A (Customer) enters into a photocopying service contract with a vendor under which a
photocopying machine is transferred to Co. A’s office for Co’s A’s exclusive use for 4 years.
The vendor is not able to replace the photocopying machine without Co. A’s approval.

The specified (identified) asset, which is the photocopying machine, is physically distinct and the
supplier (vendor) does not have any substantive rights to substitute the asset throughout the period of
use as stated in the contract, where the vendor cannot replace the photocopying machine without Co.
A’s approval.

Co. A has the right to control the use of the photocopying machine as it has the right to obtain
substantially all the economic benefits from the use of the asset where Co. A will be given
consideration for its photocopying service. Co. A has the right to direct the use of the asset as the
contract stated that the photocopying machine will be used exclusively by Co. A for 4 years.

Therefore, this is a lease contract.

Case B
Co. B (Customer) signs a contract with Junction 8 Shopping Mall to use a retail unit #02-100
for 3 years. The shopping mall management has specified that the retail unit can only be used
as a café, but Co. B has the right to decide what food and beverages to sell and the selling
price.

The monthly rental is a fixed amount plus a certain percentage of the shop’s sales proceeds.
(not part of lease payments) The shopping mall management reserves the right to ask Co. B to
relocate to another unit with compensation. The shopping mall management will benefit
economically only in the event that a new major tenant were to rent a huge retail space that
includes #02-100. Although this may be possible, it is unlikely to happen at the inception of
the contract. (lessee makes judgement at the start, no reassessment unless T&Cs change) clause is to
protect themselves and if it happens, hefty compensation given.

The specified asset, which is the retail unit #02-100, is physically distinct and the supplier (shopping
mall management) does not have any substantive rights to substitute the asset throughout the period of
use as stated in the contract as the supplier will only benefit economically under circumstances that are
unlikely to occur at the time of contract.

Co. B has the right to control the use of the retail unit as it has the right to obtain substantially all the
economic benefits from the use of the asset where Co. B will be obtaining the shop’s sales proceeds
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during the 3 years. Co. B also has the right to direct the use of the asset as the contract stated that Co. B
has the right to decide what food and beverages to sell and the selling price. (restrictions only provides
the scope, but within the scope Co.B still can decide)

Therefore, the contract is a lease.

Case C
Co. C (Customer) enters into a contract with an electricity supplier, which operates several
electricity power plants, to purchase all the electricity produced by a specific power plant for
5 years. The electricity power plant is for the exclusive use of Co. C, which will accept all the
electricity produced by the plant, the quantum of which is decided by the supplier. (Customer
has no rights to control the use) if electricity, it is not physically distinct hence not a lease)

The specified asset, which is an electricity power plant, is physically distinct and the supplier does not
have any substantive rights to substitute the asset throughout the period of use as stated in the contract,
since Co. C will accept all electricity produced by the specific power plant exclusively.

Co. C has the right to control the use of the electricity power plant as it has the right to obtain
substantially all the economic benefits from the use of the asset where Co. C has exclusive use of the
electricity power plant. However, Co. C does not have the right to direct the use of the electricity power
plant as it was stated in the contract that the quantum of electricity to be supplied to the Co. C is
decided by the supplier.

Therefore, this is not a lease contract.

Question 2

Co. B (lessee) enters into a 10-year lease of a floor of a building, with an option to extend for
five years on 1 January 20x1. Lease payments are $50,000 per year during the initial term and
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 $55,000 per year during the optional period, all payable at the beginning of each year. (50k for
10 years non-cancellable, 55k for extended 5 years)

To obtain the lease, Co. B incurs initial direct costs of $20,000. As an incentive to Co. B for
entering into the lease, the lessor agrees to reimburse to Co. B the real estate commission of
$5,000. ($20k - $5k)

At the commencement date, Co. B concludes that it is not reasonably certain to exercise the
option to extend the lease and, therefore, determines that the lease term is 10 years. (if its
reasonably certain, lease term will be 15 years)

The interest rate implicit in the lease is not readily determinable. Co. B's incremental
borrowing rate is 5 per cent per annum, which reflects the fixed rate at which it could borrow
an amount similar to the value of the right-of-use asset, in the same currency, for a 10-year
term, and with similar collateral.

Assume Co. B recognises the lease, adopts cost model and straight-line depreciation.

Required:
Prepare appropriate journal entries for Co. B for the year 20x1. Assume a December 31 year-
end.

Lease term: 10 years, Interest rate: 5%

PVIFA = (1-(1+r)^-n/r (n=9)
Lease liability = PV of lease payment = c + c/i (1 - 1/(1+i)^n-1) = [ 50,000 + 50,000/0.05 (1 –
1/(1+0.05)^10-1) ] = $405,391 (*Always calc lease liability first, ROU has more components)

Cost of ROU Asset = PV of lease payment + Initial Direct Cost – Incentive Receivable = $405,391 +
$20,000 - $5,000 = $420,391

1 Jan 20x1
DR ROU Asset $405,391
CR Lease Payable $355,391
CR Cash $50,000
(To record lease of premise and first payment)

DR ROU Asset $20,000

CR Cash $20,000
(To record initial direct cost paid by lessee)

DR Cash $5,000
CR ROU Asset $5,000
(To record reimbursement by lessor)

DR ROU Asset 420,391

CR Lease payable 355,391
CR Cash  65,000

31 Dec 20x1
DR Interest Expense $17,770
CR Interest Payable $17,770
(To record interest expense on lease liability)

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[5% x (405,391 – 50,000)]

DR Depreciation Expense $42,039

CR Accumulated Depreciation $42,039
(To record depreciation expense)
($420,391/10)

Not Required (1 Jan 20x2) P&L impact is in 20X1 hence it is NOT interest expense in 20X2
DR Lease Payable $32,230
DR Interest Payable $17,770
CR Cash $50,000
(To record yearly lease payment)

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Question 3

JK Ltd leased equipment to Co. EF for 8 years, at which time the asset will revert to JK Ltd.
The equipment cost JK Ltd $16m and has an expected useful life of 12 years. Its selling price
is $22.4m. The present value of the lease payments is $20.4m. The first payment was made at
the commencement of the lease.

Required:
How should JK Ltd classify this lease and why? (Lessee no need to classify, use lessee single
accounting model unless short term & low value)

Expected useful life: 12years

Lease term: 8/12 = 66.67% which is less than 75% of the economic life of the equipment

The present value of the equipment is 20.4m, fair value = 22.4m

20.4/22.4 = 91.07% which is more than 90% of the fair value of the equipment.

From the viewpoint of a lessor, JK Ltd should classify this lease as a finance lease (as long as one
condition is met) since the present value of the lease payments is a substantial amount of the fair value
(20.4/22.4 = 91.07%)

(Additional)
DR Lease Receivable $22.4m
DR Cost of Goods Sold $16m
CR Sales Revenue $22.4m
CR Inventory of Equipment $16m

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 Question 4

Co. X leased equipment from Co. Y on January 1, 2014. Co. Y purchased the equipment at a
cost of $222,666.

Required:
Prepare appropriate journal entries for Co. Y (lessor) for 2014. Assume a December 31 year-
end. (finance lease: lease term 100% of UL of asset) alw use implicit interest rate
Lease term: 3 years, Interest rate: 8%
Lease liability = PV of lease payment = c + c/i (1 - 1/(1+i)^n-1) = [ 80,000 + 80,000/0.08 (1 –
1/(1+0.08)^3-1) ] = $222,661
ROU = $222,661

1 Jan 2014
DR Lease Receivable $142,661
DR Cash $80,000
CR Equipment $222,661
(To record lease and first payment received)
($222,661-$80,000)

OR

DR Lease Receivable 222661

CR Equipment 222661

DR Cash 80000
CR Lease Receivable 80000

(First payment: No interest component)

31 Dec 2014
DR Interest Receivable $11,413
CR Interest Income $11,413
(To record interest income earned)
8% x ($222,666-$80,000)

1 Jan 2015
DR Cash $80,000
CR Interest Receivable $11,413
CR Lease Receivable $68,587
(To record yearly lease payment received)

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Question 5

On 1 January 20x1, Success Co. entered into a lease agreement to lease a highly specialised
machinery (which had a useful life of 20 years) from Victory Leasing Co. (lessor) from lessor
pov, it is a finance lease. Lease receivable (same calc as lease liability)

Victory Leasing Co. had bought the new machinery for a cash consideration of
$1,122,095.

The terms of the lease agreement included the following:

1. Non-cancellable lease term of 15 years, with a renewal option for another 5 years
2. Lease rental of $100,000 per year for the first 15 years and $50,000 per year for the
last 5 years (if the option was exercised), to be paid on 31 December of each year,
commencing 31 December 20X1
3. If the lease was extended to 20 years, Success Co. had to pay $150,000 to dismantle
the machinery (paid at the end of the 20years)

At the commencement date, Success Co. was reasonably certain that it will extend the lease
to 20 years. (lease term: 20yrs)

The rate of return of the lease was 5%. Success Co.’s incremental borrowing rate was 4%.

The initial direct cost paid by Success Co. was $20,000. Victory Leasing Co. had also paid
$20,000 of initial direct cost. (lessee lessor IDC was 20k)

Assume the asset was depreciated using straight-line basis with no residual value.

Required:
Prepare appropriate journal entries for Success Co. (lessee) and Victory Leasing Co
(lessor) for the year 20x1. Assume a December 31 year-end.
JE at inception, end - include date and short narration
Success Co. (payment at the end of the year)
Lease liability = PV of lease payment = c + c/i (1 - 1/(1+i)^n-1) = 100,000 + 100,000/0.05
(1+0.05)^(15-1) = 1037966 (check calc)

5yrs renewal (50k/year), 150k dismantling cost

50k x PVIFA (5%, n=5) = $216,474 (amt as at end of 15year)

100k x PVIFA (5%,15) = $1,037,966

PVIF (5%,15): $104,128
Lease liability = $1,142,093

For Success Co (lessee), we use the incremental borrowing rate of 4%.

ROU asset (includes other components eg dismantling cost)
Provision for dismantling cost = $150k x PVIF (4%,20) = $68,458
IDC: $20,000
ROU = $1,142,093 + $68,458 + $20,000 = $1,230,551
5% x 1,142,093 = 57,105
ROU asset/20 years = 61,528
Overtime, unwind the discount on the provision such that at the end of the period, it will go up.
4% x 68458
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 PV LP + unguaranteed RV (PV) = FV machinery + IDC
Lease liability for the lessee and lessor not the same all the time (different interest rate used,
residual value)

Question 6

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SA Ltd manufactures equipment for sale or lease to other companies. On 1 January 20X1, SA
Ltd entered into a sales-type lease agreement with a customer.

The market selling price of the equipment is $125,000. The cost to SA Ltd is $100,000. Each
equipment has a useful life of 5 years, with residual value expected to be insignificant. Fair
market interest rate is 6% per annum.

This lease agreement is for 5 years with annual payment of $29,675, commencing 31
December 20X1.

Required:

a) Prepare the journal entries for SA Ltd on 1 January 20X1

b) Assume that in order to promote sale of the equipment, SA Ltd advertised that it will
charge an interest of only 3% per annum. (to attract sales, mkt rate is 6%) Prepare the
journal entries for SA Ltd on 1 January 20X1

(a) 1 Jan 20X1

DR Lease Receivable $125,000
DR Cost of Goods Sold $100,000
CR Sales Revenue $125,000
CR Inventory of equipment $100,000

$29,675 x 5 =148,375
Interest Income = Gross Investment – FV = $148,375 - $125,000 = $23,375

c + c/i (1 - 1/(1+i)^n-1)
PVIFA
Always use the lower value
FV/PV = 125k (n=5, i/r=3%) (instead of 6%)
PMT = $27,295 (instead of 29k)

Cost 100k, Gross Investment = 27,295 x 5 = 136,475

PMT = 27,295, n=5, mkt i/r = 6%

PV = $114,976

DR Lease receivable 114,976

DR COGS 100,000
CR Sales Revenue 114,976
CR Inventory 100,000

GP = $14,976

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